Source: Microeconomic Theory, Texas A&M University
Tags: cartel, collusion, cheating on cartel, cartel instability, advertising, monopolistic competition advertising, cooperative equilibrium, defection, brand loyalty, advertising game theory, ATC with ads, ATC without ads
Cartels form when oligopolists agree to restrict output and raise prices, mimicking a monopoly outcome. The problem is that every member has an incentive to cheat by producing more than their quota, which is why cartels tend to break down. Advertising is a key competitive tool in monopolistic competition: it shifts demand and raises ATC, and whether it leads to higher or lower long-run prices depends on how much extra demand it generates.
Cartel
A formal or informal agreement among competing firms to coordinate output, pricing, or market allocation in order to increase collective profits. Essentially, firms acting together as a monopolist.
Collusion
Any agreement among firms to restrict competition, whether by fixing prices, dividing markets, or limiting output. Cartels are the most structured form of collusion.
Cheating (on a cartel agreement)
When a cartel member secretly produces more than its agreed quota to capture additional profit at the expense of other members. This is the primary reason cartels are unstable.
Cooperative equilibrium
The outcome where all cartel members honour their agreement, restricting output to the profit-maximising level. This is not a Nash equilibrium in a one-shot game because each member has an incentive to deviate.
Advertising (as a competitive tool)
Spending by firms to increase demand for their differentiated product. In monopolistic competition, advertising shifts the demand curve rightward but also raises average total cost.
ATC with advertising (ATC_ads)
Average total cost inclusive of advertising expenditure. Always sits above the no-advertising ATC curve because advertising is an additional fixed cost.
A cartel behaves like a single monopolist controlling the entire market:
It faces the market demand curve (D) and the associated marginal revenue curve (MR).
It sets total output where MR = MC for the industry as a whole.
In the chapter's example, total cartel output is 120 million pounds per month at a price of $0.45 per pound, with MC = ATC = $0.15.
Cartel profit is the shaded rectangle: ($0.45 - $0.15) x 120 million = total cartel profit, divided among members by quota.
Each member is allotted a quantity such that the sum equals the profit-maximising total (120 million pounds).
Every cartel member faces a temptation. If a firm secretly produces beyond its quota while everyone else sticks to theirs:
Total market output rises (from 120 to 140 million pounds in the example).
The market price falls (from $0.45 to $0.40).
Total cartel profit falls.
But the cheater's individual profit rises, because it sells a larger quantity at a price still above its cost.
The cheater gains at the expense of the other members. This is a prisoner's dilemma at the industry level: each firm's individually rational choice (cheat) leads to a collectively worse outcome (lower total profit, possible cartel collapse).
This is the fundamental reason most cartels eventually break down without an enforcement mechanism.
Because monopolistically competitive firms sell differentiated products, advertising is one of their main competitive tools. The chapter analyses two possible long-run outcomes of advertising.
Starting from long-run equilibrium with no advertising (P = $60, Q = 1,000):
Advertising shifts demand rightward (from d_no ads to d_ads) and makes it less elastic (stronger brand loyalty).
ATC rises from ATC_no ads to ATC_ads because advertising is a cost.
New long-run equilibrium: P = $100, Q = 1,750 (point B).
The price is higher because the demand shift and reduced elasticity outweigh the cost increase.
Same starting point, but this time:
Advertising shifts demand rightward by a larger amount relative to the cost increase.
The greater volume allows the firm to spread its fixed costs (including advertising) over more units.
New long-run equilibrium: P = $50, Q = 2,000 (point C).
The price is lower than the no-advertising equilibrium because economies of scale from higher volume more than offset the advertising cost.
The outcome depends on the relative size of the demand shift versus the cost increase. There is no universal rule that advertising raises or lowers prices.
The chapter presents an advertising game between United and American airlines. Both can choose to run safety ads or not:
If neither advertises: both earn medium profit.
If both advertise: both earn low profit (advertising costs cancel out because both are doing it).
If one advertises and the other does not: the advertiser earns high profit, the non-advertiser earns very low profit.
Running ads is a dominant strategy for both airlines. The Nash equilibrium is (Run ads, Run ads), even though (Don't run, Don't run) would give both firms higher profits.
This is another prisoner's dilemma. Each firm advertises defensively to avoid losing market share, even though the advertising largely cancels out when both do it.
⚠️ Know why cartels break down: each member's incentive to cheat. Be able to explain using the prisoner's dilemma framework.
⚠️ The cartel's profit-maximising rule is the same as a monopolist's: produce where MR = MC for the market. The difference is that output must be allocated among members.
⚠️ When cheating occurs, the market price falls for everyone, not just the cheater. Total cartel profit falls, but the cheater can still gain individually.
⚠️ Advertising can raise or lower long-run prices in monopolistic competition. Be ready to explain both scenarios and what determines which outcome occurs.
⚠️ The advertising game between rivals is structurally identical to the prisoner's dilemma. Both firms advertise (the dominant strategy), but both would be better off if neither did.
Q: How does a cartel determine its profit-maximising output?
A: It finds the output level where the industry's marginal revenue equals marginal cost (MR = MC), then allocates that total output among its members by quota. The price is read from the market demand curve at the chosen total output.
Q: A cartel member is considering producing 20 million pounds above its quota. Why is this individually attractive, and what happens to the market?
A: The cheater sells more units at a price that, while lower than the cartel price, still exceeds marginal cost, so the cheater's own profit rises. But total market output increases, the market price falls for all members, and total cartel profit declines. The non-cheating members bear the cost.
Q: In monopolistic competition, how can advertising lead to a lower long-run price?
A: If advertising generates a sufficiently large increase in demand, the firm produces a much higher quantity. The higher volume spreads all fixed costs (including advertising) over more units, reducing ATC enough that the new long-run equilibrium price is lower than it was without advertising.
Q: Why is the advertising game between two rival firms a prisoner's dilemma?
A: Each firm's dominant strategy is to advertise, because not advertising while the rival does would mean losing significant market share. But when both advertise, the effects largely cancel out and both earn lower profit than if neither had advertised. Individual rationality (advertise) leads to a collectively worse outcome.
cartel, collusion, cartel instability, cheating on cartel, quota, MR equals MC, monopoly pricing, cartel profit, advertising game, prisoner's dilemma advertising, dominant strategy, brand loyalty, demand elasticity, ATC with advertising, ATC without advertising, economies of scale, long-run price effect of advertising, cooperative equilibrium, defection incentive, OPEC, oligopoly collusion